I Told You So

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To controversial securities litigator Bill Lerach, the current wave of corporate fraud scandals was both inevitable and preventable.

Seven years ago, Congress overrode President Bill Clinton's veto and passed the Private Securities Litigation Reform Act of 1995 (PSLRA). The legislation was hailed as a victory for corporations over lawyers who filed what CEOs regarded as frivolous shareholder lawsuits, or "strike suits," as some called them. In particular, the act was viewed by many executives as a big thumb in the eye of one notoriously litigious attorney: William S. Lerach.

But the act only briefly stemmed the tide of shareholder litigation. And it hardly put a dent in the caseload of Lerach, a senior partner at the law firm of Milberg Weiss Bershad Hynes & Lerach and the poster boy for securities fraud actions. (In Silicon Valley, to be "Lerached" is slang for being sued.) Today, the PSLRA is being reviled as a catalyst of the accounting scandals plaguing Corporate America, while shareholder complaints resulting from those scandals are stacking up on Bill Lerach's cluttered desk.

Talk about irony. Of the 303 non­initial public offering allocation class-action securities suits settled in the United States between 1996 and 2001, more than half were brought by Lerach and his colleagues, according to statistics compiled by Cornerstone Research. And this year, he's leading the plaintiffs' charge in the two biggest corporate scandals. Last February, Lerach was named lead attorney in the class-action case against Enron, a case he calls the "professional challenge of a lifetime." And in March, a shareholder case that he insists documented many of the alleged abuses at WorldCom well before the company admitted to more than $7 billion in accounting irregularities was dismissed by a federal district court judge in Mississippi.

Against both companies, Lerach, who has brought some 600 class-action cases to date, is now casting a wide net of responsibility. Representing the University of California Board of Regents in the $25 billion Enron suit, he has made headlines by suing nine investment banks, including J.P. Morgan Chase & Co. and Citigroup, as well as the company's legal counsels and what's left of Arthur Andersen. Lerach is also pursuing many of the same banks in state courts on behalf of three California pension funds, including the California Public Employees' Retirement System, for the banks' involvement in a May 2001 bond offering for WorldCom.

All this might have been avoided, he says, if the PSLRA hadn't been passed. Many of the disgraced executives at WorldCom, Enron, Adelphia, and elsewhere "would have been sued earlier and publicly exposed." And that, says Lerach, would have had "the prophylactic impact on corporate conduct that private litigation and securities law was always meant to have." Specifically, Lerach blames the law's tighter filing standards and its safe-harbor rule, which protects executives who make forward-looking statements, for the surge in executive chicanery.

The slew of executives being sued has put the 56-year-old Lerach back in the spotlight. Recently, he sat down with CFO deputy editor Lori Calabro at his office in San Diego, surrounded by 10-Ks, legal briefs, and other documents, to sort through the mess created by recent financial fraud. Lerach makes no apologies for his tactics, or for the millions he has made from suing companies.

"I really love the American financial markets. There's nothing like them in the world," says Lerach. "And if we can play a role in making those markets healthier, we play a constructive role in society. And if we make a lot of money while we do that, then we are like a lot of other people who contribute positively to society, whether it is a brain surgeon or an entrepreneur or a corporate executive."

You've been warning about "accounting rot" and "massive securities fraud" for years. Do you feel vindicated?

Someone once told me that the four worst words in the English language are "I told you so." But we told people this was coming. And it wasn't just because we are skeptical by nature or that we represent investors suing public companies. Remember, in case after case, we got to see the internal financial records, the accounting work papers, of these companies that were secreted from public view by protective orders.

What did you observe?

We saw case after case of deliberate falsification of financial results. We saw the way the investment banks got IPO business or secondary business by promising that an analyst would issue a favorable report as soon as the quiet period was over. And while many times the consulting done by the accounting firms was concealed, we saw enough to realize that the fees were way higher than generally thought. But did I think this was going to happen? Honestly, I didn't really foresee this kind of massive blowup. I don't think anyone could have.

Obviously, it was a confluence of events that got us to this point. But if you had to name the top three, what would they be?

Stock options, stock options, and stock options! They completely poisoned the system. Misaligning incentives and interests caused corporate managers to become completely focused on short-term results and do whatever was necessary to meet expectations because they were going to exercise stock once the window opened.

Who do you blame for that?

A terrible misjudgment was made in 1991 by the Securities and Exchange Commission. Under pressure from the corporate community, they changed the rule under section 16B of the 1934 act--the short-swing profit rule--which says that if a corporate insider buys and sells stock in six months, it is presumed to be on insider information, and the profit belongs to the company. It was a bedrock insider-trading preventative.

The SEC adopted a regulation that says for 16B purposes, a [stock option] purchase occurs when the option is granted, not when it is exercised--even though when the option is granted it is not vested, the executive does not have the ability to exercise the option, and the executive has no capital at risk. The practical impact of this is that options are granted, six months runs, options begin to vest, executives exercise the options at 8:01, they sell the stock at 8:01:30, they put the profit in their pocket. When people have the opportunity to pocket millions and millions of dollars--in some cases, hundreds of millions--without risk, what do you think they are going to do?

How personally liable do you hold the CEOs--and especially the CFOs--for the fraudulent activity that we've seen?

It can't happen without the CFO. But what I find hysterical is the idea that the CEO didn't know. The notion that Bernie Ebbers [CEO of WorldCom] didn't know what [CFO Scott] Sullivan was doing is laughable. What strikes me as unfair, though, is that CFOs get so little out of it compared with CEOs. They are paid less, their options are less lucrative, and, frankly, they don't sell [stock] the way that a CEO sells. In fact, when I investigate a situation, if I find significant sales by a CFO, that is a tremendous red flag.

How widespread do you think these scandals will get?

It really can't get worse than this, can it? I love financial history, and often talk about 1929. And while I don't want to predict anything like that, the rot then went on for years and years, and ultimately resulted in a buyer's strike in terms of equities.

Do you believe the scandals and restatements will continue to be sector-based?

We just happen to be highly focused on energy and telecom at the moment. Watch next for the bad loans at the banks. Consumers and some companies are not going to be able to pay their debts. So we'll see a cycle where the banks' financial statements fall apart. What about pension accounting? How many companies are doing their pension accounting based on 8 or 9 percent annual returns? The chickens are going to come home to roost on that one someday, and companies will have to put tons of money into those plans, meaning they will have overstated their earnings for many years before that. Dishonest accounting cuts across all business sectors in time.

What do you think are the worst accounting abuses?

For the most part, we've focused on bogus revenue recognition. But I think companies also mess with the amortization and depreciation rates of their assets, and there's no question that the mergers-and-acquisitions boom gave companies an opportunity to bury all kinds of things in one-time charges.

Are there any easy fixes?

If the SEC really wanted to clean up accounting, they'd make companies, in their quarterly results, reveal the five largest reserve adjustments that they made.

What's the status of the Enron case?

The case is tied up in a procedural phase whereby the consolidated complaint [is reviewed]. The defendants have all come forward and said the complaint isn't specific enough or the complaint is too long or one thing or another. So the judge will have to decide if it is sufficient, and she'll do that very shortly.

Absolutely. There's no question that the 1995 act made it much more difficult for victims of securities fraud to adequately plead their case. It provides all kinds of protections against joint and several liability. Its safe-harbor provision provides immunity from false forecasts under some circumstances. And the defendants in Enron are invoking every single one of those protections. I don't think they will be successful. But a lot of people have been able to hide behind the '95 act, including Bernie Ebbers and WorldCom in a case we filed in 2001 that was thrown out in March. Had that case been allowed to go forward, I don't think the scandal would have been nearly as bad.

How much do you blame the 1995 law for where we are today?

A lot. I've known the lawyers for many of these big companies for many years. And privately, they have told me that there is no question that the '95 act emboldened executives to think they could do whatever they wanted.

You actually have called it the Corporate License to Steal Act.

"License to Lie." The safe harbor is actually a license to lie. Can you imagine that we went from a rule that originally said public companies could not make any forecasts--because it was viewed as so potentially misleading--to a situation now where apparently they can lie about forward-looking information and not be held accountable legally? That's an intolerable situation.

The 1995 act was supposed to rein in securities lawyers--specifically you--but in the past three to four years, we've seen a proliferation of shareholder suits.

How do you explain that?

You have to be careful. If you back out the IPO cases, the cases related to "laddering" [whereby investors were required to accept shares at higher prices in the aftermarket as a condition for receiving IPO shares] and the like, it drops the numbers dramatically. In addition, many cases simply can't be brought, because there isn't enough detail. And the statute of limitations--although this wasn't done in the '95 act--is only one year for a fraud claim. [The Sarbanes-Oxley Act lengthened that time to two years.] That's an extraordinarily short statute of limitations. Most states provide five or six years for fraud claims because they know that it takes years for the frauds to come out and for the victims to be able to sue.

But do you consider it a bad act entirely? After all, because of it, you have the University of California Regents as the lead plaintiff in the Enron case.

Other than the lead-plaintiff provision, which encouraged institutional investors to come forward, there was nothing good about the 1995 act. It was written almost entirely by corporate and accounting firm lobbyists. And I don't think the people who passed the lead-plaintiff provision had any idea what it would end up doing. [The provision authorizes courts to name investors seeking the greatest financial relief as plaintiffs in class-action suits.]

What has happened, though, is that it has encouraged institutional investors to come forward. And when you combine that with the massive upsurge in fraud and the resulting interest in improved corporate governance, you are going to see almost all of these cases going forward prosecuted by institutional investors.

As the lead lawyer in Enron, how much pressure is there to maximize recovery for everyone? So much--$20 billion--was lost overall.

This represents the professional challenge of a lifetime. We've got a bankrupt company; we have $350 million in D&O insurance that carriers are going to try to rescind; we have an accounting firm that is a wisp of smoke; and even if we were to get precedent-breaking recoveries from individuals, it is still going to be small compared with the overall loss. So you really come down to pursuing these big Wall Street banks.

What are the legal grounds for pulling the banks into the litigation?

We have to show that the banks participated in a scheme to defraud or a course of business that operated as a fraud on the purchasers of Enron's securities. Now, the banks will say that that kind of liability doesn't exist. That's a key legal decision the judge is going to have to make. Assuming she decides that fraudulent scheme and course of business liability still exists, then we have to prove that the banks participated in that either knowingly or in reckless disregard of the consequences of their conduct, and I'm confident we will be able to do that.

You've charged the banks with creating "a large Ponzi scheme" in which they were the main beneficiaries. How culpable are they?

The banks are terribly culpable. These top banks were involved in Enron's day-to-day business operations. They helped them structure these SPE [special-purpose entity] transactions that were used to falsify the financial results; they helped them structure and fund the partnerships that were actually used not to create phony earnings for Enron, but to loot Enron. And banks were the primary beneficiaries of that. Not only the banks themselves, but also the executives in the banks who were secretly invested in those partnerships. And when this comes out--and it will--it is going to be monumentally embarrassing to a number of top bankers on Wall Street.

What do you say to the critics who charge that you are going after the banks and these other parties only because they have deep pockets?

It's true. My job as a lawyer is to recover money for my clients who were defrauded, and to do that by pursuing all the responsible parties. I wish Enron was still around and had money and could pay, but that's not the way it is.

What reforms would you like to see in a post-Enron world?

If I gave you my wish list, it would be pretty long. I'd like to see the '95 act modified, of course. But I also think that there ought to be a federal corporation law, and that corporate governance ought not to be left to individual states. Look at the Delaware situation. It doesn't make sense for a domestic Liechtenstein, in effect, to provide a haven for these multinational and national corporations. [A federal law] would get rid of the liability raincoat that protects Delaware directors from their negligence and dereliction of duty. I mean, who should pay back Bernie Ebbers's $408 million loan? How about the directors who authorized that ridiculous loan in the first place?

What advice do you have for CFOs?

CFOs really have to go back to basics. You've got to trust that America's investors will reward you if you are honest, even if you are conservative. If you expense your options, if you give them better transparency, if you create a culture of trust about your company, you'll get rewarded for that. That's what was wrong with the old system: you were rewarded for just the opposite kind of behavior--phony growth, pro forma, EBITDA.

A recent study found that CFOs are being named more and more in securities suits--74 percent of the time this year, compared with 67 percent last year. Is this a trend?

It is.

So CFOs should be on notice?

On guard.

(Editor's note: Take a look at the CFO PeerMetrix interactive scorecards to see how companies are controlling costs, keeping an eye on working capital, managing their level of cash on hand, and holding down their effective tax rate.)

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